The SEC Brings Intrastate Offering Rules Into the Modern Era
By SBE Council at 2 November, 2016, 3:28 pm
by Andrew Stephenson-
(This article first appeared on Locavesting)
On October 26, 2016, the Securities and Exchange Commission (SEC) approved final rules amending Rule 147 and creating new Rule 147A. The much needed update brings many beneficial changes for local businesses looking to raise capital within their states, including the ability to advertise across state lines and to conduct multiple offerings without fear of running afoul of securities laws. But challenges remain—for example, businesses conducting intrastate offerings will still be at risk of triggering public reporting requirements if they have too many unaccredited shareholders and over $10 million in assets. In this article, Andrew Stephenson of CrowdCheck takes a deeper look at new intrastate offering rules and what they mean for issuers.
Background on Rule 147 and intrastate crowdfunding
Rule 147 is a safe harbor established by the SEC to clarify some ambiguities present in Section 3(a)(11) of the Securities Act. Section 3(a)(11) declares that intrastate offerings of securities (in which the company is incorporated or organized in-state, does business in state, and makes offers and sales of securities to in-state residents only) are exempt from federal registration requirements. Rule 147 provides clarity for what it means to be doing business in state and how to determine if a person is a resident of the state, among other things.
In the past few years, many states have adopted intrastate crowdfunding rules that require companies to comply with Section 3(a)(11) and Rule 147. This means that any company using a state crowdfunding exemption must be incorporated or organized in the state and cannot make offers to residents outside of the state. In practice, this offering restriction has meant that internet based communications are off-limits because they are inherently an interstate form of communication and result in offers of securities being made to residents outside of the state. Section 3(a)(11) and old Rule 147 were not written for the information age.
The SEC received requests from its Advisory Committee on Small and Emerging Companies, as well as from participants at its annual SEC Government-Business Forum on Small Business Capital Formation to update and modernize Rule 147. The new rules respond to those requests.
Amendments to Rule 147 and adoption of Rule 147A
The SEC amended Rule 147 as well as created new Rule 147A. Rule 147 continues to be a safe harbor for compliance with Section 3(a)(11) of the Securities Act, while Rule 147A was enacted under the SEC’s general exemptive authority. By using two rules, the SEC was able to create an intrastate offering exemption under Rule 147A that is not linked to Section 3(a)(11), while maintaining the existence of Rule 147, on which many intrastate crowdfunding rules rely. Preserving Rule 147 allows for a transition period for states to adjust their laws and rules. Rule 147A, by not being based on Section 3(a)(11), allowed the SEC to modernize the exemption for modern business practices of organizing in a state with established bodies of corporate law (such as Delaware), while doing business in another state. Additionally, the exemption allows for offers of securities to be made broadly (i.e., over the internet) so long as sales are only made to residents in the state.
Common elements of Rules 147 and 147A
In the rules, there are common elements for both amended Rule 147 and new Rule 147A. These elements update the requirement for issuers for “doing business” in-state; establishing a reasonable belief of the investor’s state of residence; shortening the holding period for resales; clarifying integration considerations; and disclosures to investors.
Under pre-amended Rule 147, to meet the “doing business” requirement, any issuer must derive 80% of its gross revenues from in state, have 80% of its assets in the state, and use 80% of the net proceeds from the offering will be used in state. The amended rules change this formulation to allow more flexibility. The issuer must now meet just one of the following criteria: derive 80% of its revenues from the operations of a business or property in state (allowing for revenues to come from out of state), have 80% of its assets in the state, use 80% of the proceeds from the offering in state, or have a majority of its employees in the state.
While pre-amended Rule 147 merely prohibited sales to non-residents of the state, the amended rules require that the issuer have a reasonable belief that the investor is a resident of the state. The SEC specifically cautions that a written representation, without more, is not sufficient to establish a reasonable belief. Entities will be considered residents of the state if they meet the doing business test for issuers.
Additional changes include shortening the holding period for secondary sales of securities to six months from the date of the sale to the specific investor, rather than the previous nine months, as well as specific disclosure language to be included in a legend placed on the securities and in any offering materials to investors.
Pre-amended Rule 147 did not include any provisions regarding integration with another offering. Integration is the securities law principle that two or more offerings of securities may be considered to be one offering for purposes of determining whether an issuer was in compliance with the Securities Act. Without an integration safe harbor, it was always possible that an intrastate offering would be invalid because the issuer conducted another offering too soon before or after its intrastate offering that did not meet the requirements of Section 3(a)(11) and Rule 147, or that the other offering would have required registration under the Securities Act. A finding that the issuer was not in compliance with the Securities Act because multiple offerings were integrated creates the possibility that the issuer would be in violation of Section 5 of the Securities Act.
The new rules provide clear guidance that intrastate offers and sales under Rule 147 or Rule 147A will not be integrated with completed offers and sales of securities. Additionally, offers and sales under Rule 147 or Rule 147A will not be integrated with subsequent offers and sales of securities that are registered under the Securities Act, exempt under Regulation A or Rule 701, made under an employee benefit plan, exempt under Regulation S, exempt under Section 4(a)(6) (i.e., Title III crowdfunding), or done more than 6 months after the intrastate offering.
Rule 147A specific features
While Rule 147 is only available to issuers making offers and sales of securities in the state in which it is both organized and does business, Rule 147A removes the restriction on in state organization and in state offers.
As a result, a company that has decided to register in Delaware, Nevada, Wyoming, or elsewhere because of business considerations but meets the “doing business” test may still take advantage of the Rule 147A exemption from registration. Additionally, by removing the limitation on offers, an issuer may use any form of mass media, including unrestricted, publicly-available websites to offer the securities so long as sales are made only to residents of the state in which the issuer is doing business.
Because many states adopted their intrastate crowdfunding rules in accordance pursuant to issuer compliance with Section 3(a)(11) and Rule 147, Rule 147A will not be available for issuers until their states amend their own rules governing intrastate crowdfunding to require compliance with Rule 147A instead.
The SEC also used the rule-making to clarify whether an intrastate broker-dealer can use the internet to facilitate capital formation by its clients. The SEC agreed that the use of the internet, so long as the broker-dealer prominently displays that its activities are exclusively intrastate, will not result in the loss of the federal exemption from registration for intrastate broker-dealers. This is very helpful for many state-registered intrastate crowdfunding platforms.
One change that the SEC declined to make was the creation of a conditional exemption from the registration requirements of Section 12(g) of the Exchange Act. Under Section 12(g), any company that has $10 million or more of assets and equity shares held by 500 or more non-accredited investors must comply with the quarterly and annual reporting requirements of the Exchange Act (as publicly traded companies do). Without a conditional exemption for this reporting, issuers will need to be careful to stay under the reporting thresholds, or to only offer non-equity securities.
Issuers will also not be able to use special purpose entities or investment vehicles to limit the number of shareholders of record. Section 24(d) of the Investment Company Act excludes any entities that are registered or would be required to register as investment companies from using Section 3(a)(11) of the Securities Act, and thereby may not use Rule 147. The SEC extended this prohibition in Rule 147A as well.
These new amendments to Rule 147 and adoption of Rule 147A are good news for small companies planning an intrastate crowdfunding campaign. Rule 147A in particular will allow companies to better utilize social media and other online communication forums to support their capital raising efforts. These changes also make it easier to determine whether a company qualifies as “doing business” in the state, facilitating compliance with the rules. Now, it is up to the states to act to adjust their intrastate crowdfunding rules to make Rule 147A an option for companies.
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Andrew Stephenson is vice president of product management and Strategy for CrowdCheck, Inc., which provides due diligence, disclosure and compliance services.